Integrating financial markets has become more challenging, with the global financial system still struggling to remove distortions that led to the worldwide financial crisis in 2007-08, and with the structural flaws persisting in the domestic financial system.

But policymakers are, somehow, pursuing this goal to achieve broader objectives of ensuring stability in exchange and interest rates, obtaining responsible stock market behaviour, and enhancing due contribution of financial services in economic growth.

“Rationality becomes rare and volatility abounds when markets aren’t well integrated,” says a senior SBP official. “Speculation-driven fall in the rupee’s value, low-level financial intermediation of banks, slow development of yield curve and undependable portfolio investment inflows — all indicate that our financial market needs a bit more integration.”

Interest rates are bound to be influenced by changes in share prices and exchange rates. And exchange rates and interest rates have an impact on share prices, which, in turn, again influence interest and exchange rates.

A successful transmission of monetary policy has a more rational impact on the stock market. And market-driven movements in share prices, based on basic indicators of companies’ financial health, affect banks’ returns to depositors. Banks’ deposit rates influence domestically-driven inflow or outflow of funds from the stock market, besides causing changes in the cost of the government’s borrowing from non-bank sources.

“So, things are complicatedly interdependent,” remarks the treasurer of a large local bank. “Unless each segment of the financial market is fully developed and well regulated, smooth working of the overall financial market remains elusive.”

Moves are underway to integrate the financial market both vertically and horizontally. “The SBP has come a long way in vertically integrating the banking system,” says a senior SBP official.

“Banking reforms of the 1990s were aimed at improving their performance, but in the 2000s, we focused on making banking operations more transparent by requiring more disclosures. Together, these things helped our banking system brave external shocks in the wake of the global financial crisis in 2007-09.”

Central bankers also cite the ongoing re-capitalisation move; the introduction of the minimum deposit rate some years ago and its recent linking with the SBP’s repo rate; the introduction of interest rate corridors; separate regulation and oversight of Islamic banking windows of conventional banks and the development of an inter-bank Islamic money market as some of the things that have contributed to integrity in the banking system.

“For horizontal integration (of the financial market), we’re also making significant moves, like making forex companies more transparent and capable of feeding inter-bank forex market systematically; as well as pushing development finance institutions (DFIs) into project financing, promoting venture capital, and encouraging banks to sell mutual fund products.”

Central bankers say their efforts have resulted in larger inflows of home remittances through the banking channel and expanded the outreach of microfinance institutions, and, more recently, induced banks and DFIs into project financing.

SBP officials say they have also introduced best practices in the microfinance sector and in housing finance companies, besides coordinating with the Securities and Exchange Commission of Pakistan to ensure improved oversight of non-banking finance institutions (NBFIs), including investment banks and leasing and modaraba companies.

If all of this is true, then there is something missing somewhere in vertical integration of the banking system.

Banks are still occasionally carried away by speculations on exchange rates and interest rates; deposit rates are still not high enough to attract long-term deposits; lending rates have come down but are still prohibitively high in consumer and SME financing, and banks are still shy of exploring fresh credit avenues and catering to the existing ones with professional dedication and enthusiasm.

“The regulatory framework is OK,” says a former deputy governor of the SBP. “The issue is how to dissuade banks operationally from indulging in monopolistic practices. Unless we come out of the big-five or big-six syndrome, nothing is going to happen. The SBP should not have relaxed the re-capitalisation requirements in the past, and now it ought to implement them at all costs.”

Well-capitalised banks tend to grow faster on a sustainable basis. So, recapitalisation at regular intervals means the number of closely comparable banks will rise to 10 or 12 in the not-so-distant future.

“Then the market dynamics would start changing for the better, and the remaining smaller ones would also try to catch up with the top ones. This would at least reduce the gap between the size and operational enormity of individual banks.”

In integrating the financial market, it is also important whether various segments of the market themselves really want to move towards integration, in terms of following in spirit the codes of strict discipline, which are necessary to avoid external and internal shocks.

“Since the regrouping of the NBFI and Modaraba Association in July 2010, NBFIs have been more watchful about emerging signs of these shocks,” claims an office-bearer of the association, which was formed through the merger of the Modaraba Association and the Leasing Association and by taking investment banks into its fold.

He says the move has helped in improving financial services in the country, besides providing member entities of the association an opportunity to use their collective wisdom in dealing with strategic, policy and operational issues of NBFIs.

“Regulatory oversight has also become easier, because regulators can now easily foresee how a particular piece of regulation for leasing companies, for example, can affect modarabas and investment banks or vice versa.”

Some years ago, the SECP came up with regulations demanding disclosures by NBFIs about their holding companies or the companies that owned or controlled them.

That move blocked possibilities of illegitimate intra-corporate group financing to conceal weaknesses of a particular member company within the group.

It also undermined the possibility of a few groups of companies from turning into financial conglomerates and thus able to monopolise or manipulate the financial services market. The SBP had also introduced stricter reporting requirements for banks, to discourage intra-group financing to cover up financial shortcomings.

Executives of NBFIs say integrating the financial market can give best results if the share of NBFIs is increased in the overall financial market, which remains dominated by banks.

Meanwhile, SBP and SECP officials say efforts are underway to achieve this goal and tackle some roadblocks as slow economic growth, lack of innovative products to lure investors and inclusive financial services, social and cultural bias against some financial services like insurance, the rent-seeking approach of the private sector, and the government’s lax attitude towards the development of the financial services industry.

According to the SECP, total assets of the country’s financial sector by June 2012 stood at Rs11.613 trillion, in which banks’ share was 72 per cent and that of NBFIs around five per cent. The Directorate of National Savings, insurance companies and DFIs held the remaining 23 per cent.